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Paying Self Employment Taxes on Your Business Earnings

Tax filing will be here again before you know it. I am hoping you find this brief on self employment taxes beneficial. In addition to being subject to income taxes, the income you earn from your side businesses are also subject to self employment taxes.

If you are running a website or blog with a profit motive, you are technically in business as self employed whether you have a full time job or not. As someone who is making money outside a job that pays wages, whether you run your business full-time or as a part-time gig, you are classified as being self employed by the Internal Revenue Service (IRS).

As a self employed individual, you are obligated to pay self employment taxes regardless of the type of business you are running. Many entrepreneurs are either unaware of this or just haven’t executed on the necessary for various reasons. That said, ignoring the facts don’t change the facts.

Whether done consciously or unconsciously, by rich or poor, breaking the law has equal consequences for everyone, and the consequences can be heavy.

What are Self Employment Taxes

Self employment taxes are how the government collects its share of social security and Medicare taxes from self employed individuals.  When you work in a job and are paid wages, you pay these taxes each pay period.

If you look at your paystub or year-end W2 form (an information form employers are required to send employees which detail their earnings and taxes paid for the year), you will notice that a percentage (roughly 7.5%) is withheld by your employer. If you look at your W2, Social Security and Medicare taxes are typically reported in Boxes 4 and 6.

What you don’t see on these forms is the other 7.5% that your employer is required to pay the government on your behalf. So not only does your employer pay the 7.5% withheld from your paycheck, but they also pay another 7.5% of your gross salary for a total of 15%. Because you are your own boss when you are self employed, the government collects the entire 15% from you.

And if you have a full time job and are running a side business, you pay 15% self employment tax on earnings from your side business while your employer continues to withhold 7.5% from your wages from employment.

In addition, you are obligated to pay federal income taxes on your earnings from self employment just as you are when you earn wages.  Federal tax withholdings are typically reported in box 2 of your W2 form.

How do Self Employment Taxes Work?

I will cover the two types of taxes in this discussion, self employment tax and federal income tax.  I will call the earnings on which you pay self employment tax as “self employment taxable income” and the earnings on which you pay federal income tax as “federal income taxable income”.

To keep things simple, I will not discuss state tax and city tax. These are relatively easier calculations which often depend on your federal income tax calculation.  If you get the federal income tax piece correct, chances are you will be fine with state and city tax filing compliance as well. So back to self-employment taxes.

Your employer gets to deduct the 7.5% they pay on your behalf in employment taxes from their gross income to arrive at their taxable income. To be fair, the IRS allows you to deduct half (or 7.5%) of self employment taxes from your self-employment income to arrive at your self-employment taxable income.

You are then allowed to deduct the full 15% of self employment taxes paid to arrive at your federal income taxable income.

Here is a quick example:

Let’s say you are making $20,000 a year from your blog or website net of business expenses as self employment tax is levied on net earnings.  You are obligated to pay income taxes on your earnings, plus a 15% self employment tax.

Because you are allowed to deduct half of 15% (7.5%) from your earnings to arrive at your self-employment taxable income, your earnings should be reduced by 7.5% for tax purposes.  7.5% of 20,000 is $1,500.  $20,000 minus $1,500 gets you to your self-employment taxable income of $18,500.

A 15% self employment tax on $18,500 would be $2,775. For federal income tax purposes, you are allowed to deduct the self employment taxes from your net earnings to arrive to your net income taxable income. $20,000 minus the self employment taxes paid of $2,775 brings you to a federal income taxable income of $17,225.

This equation has no impact on your earnings from employment if you are also employed while running a side business. You continue to collect your paycheck and pay taxes the same way whether or not you have a side business.

Effective Self Employment Tax Rate

Because of the 7.5% deduction from net earnings, you only pay the 15% self employment taxes on 92.5% of your earnings (100% minus 7.5%).  15% multiplied by 92.5% gives you an effective self employment tax rate of 13.875%.

When filing your tax returns, the self employment tax calculation is done on schedule SE of the IRS form 1040. Income or loss from self employment is reported on schedule C of form 1040. Self employment effective tax rates can be further reduced when you incorporate your business.

In the example above, your self-employment tax is calculated on earnings of $20,000.  If your business is incorporated, you can make the business pay you (the owner) a salary of $10,000 and $10,000 in dividend income or distributions. Why do this? Well, by drawing a salary of $10,000, you pay 7.5% (your portion) of employment taxes, and your company pays its portion of 7.5% for a total of 15% or $1,500.

The other $10,000 in dividend distribution is NOT subject to self employment taxes, resulting in $1,500 in self employment tax savings.  You are however obligated to pay income taxes on the $10,000 dividend distribution on your personal tax return. The numbers we are working with here are relatively small.

But can you imagine the savings you can generate by incorporating your business if it was larger and generating more income?  There are several other tax deductions self employed individuals can benefit from by incorporating such as travel, cell phone bills, materials, supplies, equipment, etc.

401k Retirement Accounts for the Self Employed

Yes I know this has nothing to do with self employment taxes, but I think it is a good segway to cover since we are on the topic. Some time back I wrote about how you can save more money in a retirement account than is allowed by the government. This topic revolves around establishing a self employed 401k retirement account. One example is the SEP IRA or the Simplified Employee Pension Plan Individual Retirement Account (sigh), a good alternative for many.

As a self employed individual, you cannot contribute to a 401k plan unless you also have a job that offers the plan. The SEP IRA rules allow you to contribute up to 20% (2010) of your income per year. Other plans include the self employed 401k or SE 401k for self employed people. Contribution limits to this plan vary depending on the nature of your business incorporation.

So clear as mud? Do you have more questions after reading the post than you had before starting it?  Did I omit or misrepresent any important points?

Note: Similar to paying employment taxes each pay period on wages from employment, you are obligated to pay self employment taxes in quarterly installments (consult your CPA). The actual self employment tax is slightly above 15%, and therefore the 7.5% used in the example above is slightly higher.  This impacts the rest of the percentages as well.  I used the closest round decimal points to keep the math simple and demonstrate how these work in theory as clearly as possible. Also note that the examples are over-simplified in that the OASDI portion of the self-employment tax, or the OASDI portion of the FICA tax applies only to the OASDI wage base, which is the first $90,000+. The Medicare portion of the self-employment tax and the Medicare portion of the FICA tax applies to all self-employment income. None of this should be construed as professional advice.  Read my Disclaimer for more information. 

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12 Responses to “Paying Self Employment Taxes on Your Business Earnings”

  1. Jackie says:

    Nice explanation of how incorporating could benefit you in the self-employment tax area. That’s one of those things that’s hard to wrap my head around, but it could definitely be worthwhile.

  2. krantcents says:

    Self employment taxes are levied on profits. If you are in an early stage of your business, you probably won’t have much in profits. The legal form of your company should be based on your particular needs.

    • Sunil says:

      This is a very good point. Many times I have started a business “on the fly” and have later gone back to incorporate it formally as a legal entity. The type of entity you form should be based on your needs. i.e. does one plan on drawing salary? does one want a flow through entity? is one going to involve partners? shareholders? what kind of liability protection / limitation is one seeking? Good point.

  3. Geoff says:

    Sunil, very good point about the SEP IRA. I use this and it’s a great way to reduce your tax bill.

    I actually try to find a balance each year by contributing to both a SEP and a Roth. That way part of my tax savings is immediate and part of it is deferred until retirement….another way to have a balanced portfolio.

    • Sunil says:

      interesting approach. I know many who only do the Roth once 401k or a similar vehicle is maxed out. But I also know many who prefer the Roth route and would only contribute the bare minimum to the 401k to get the employer match.

  4. Pedro says:

    interesting approach,Thank you nice explanation and very usefull

  5. Nice easy breakdown Sunil. I have been contemplating this move for sometime now as I am earning more and more money from not only by websites but also my consulting work. My sticking point is finding out how the various tax issues apply to me as an expat. I can claim the foreign earned income deduction in my federal income but still have to pay out the self employment taxes regardless of where I live. Also, I believe you can only contribute to a ROTH or a SEP IRA if you paying federal income tax. As an expat I’m exempt. Any thoughts (or corrections) on these issues? My CPA advised that a LLC is not worth it for me at the moment but then again he also didn’t advice about the dividend savings. I’m trying to find a way to have eat my cake and lose weight. Soooo, do you know of a way to a) incorporate in the US but still claim foreign earned exclusion, minimize the self employment tax but pay just enough that you are still eligible for a SEP or and IRA? I happy to share the info once I find out if you don’t know.

  6. Todd,

    You are in an interesting situation from a Roth investment perspective. I am with your CPA in this case as an LLC would simply be flow through for tax purposes assuming you are the only principal/partner. That said, why would you want to pay self employment taxes, and then additional Federal tax just to qualify for the Roth?

    There are some nuances in the code. For example, American expats who are married to non Americans overseas can convert existing traditional IRAs to Roth IRAs.

    There is also a provision in the event you are not married to a non American. Let’s say you have a relatively high balance in the IRA, but your foreign income exclusion exceeds your earnings (60k earnings vs. 85k exclusion), you may carry over the remaining 25k in exclusion to the taxable amount of the conversion to shield it from taxes. Thus you can convert strategically.

    These may not be the answers you are looking for as you are in a unique situation. I would like to know what you find out from your research and more importantly what you end up doing – I hope you come back to share?

    Would like to interview you at some point for my podcasting series when I launch it. Up for it?

    • Hi Sunil, thanks for the feedback. Short answer is YES I’d love to do an interview for the launch of your podcast. Also, while my main site does not do guest posts my Travel Blogging Focused blog does and it would be great to have you on to discuss these very issues.

      As for my situation. If I live abroad, but my LLC is incorporated in a tax friendly state like Utah, than I believe i would not have to pay federal taxes on the income. Basically I would get paid by the company, and get dividends that are protected from self employment taxes. This means that I could keep my foreign earned exclusion but also benefit from the reduction in taxable income under the self employment income. Of course I have not been able to find the exact advice that will confirm all this. My CPA is good but is too focused on domestic and in particular Rhode Island regulations. Now, on the other hand I am planning to start publishing my own information products and I could probably use the added liability protection that an LLC would allow.

      Regarding the Roth IRA, thanks for the information. But in essence if I don’t pay taxes on at least $5,000 then I’m not eligible to contribute. What I have not been able to determine is if self employment tax counts as “taxes” in this case or if it has to be federal income taxes. In general this is not as big of a concern as currently I put non taxed funds (foreign exclusion tax) directly into investments. Since I work for the UN I don’t have to pay local taxes where I live. So I have in effect a ROTH set up already, but I’ll have to pay taxes in the future.

      Ok, I have highjacked this threat enough 🙂 I would be happy to share my information when it is available and more than happy to contribute and support your site as I can! As you can see, I might be a humble travel blogger, but I am very conscious of my earnings and savings.

      • Sunil says:

        Thanks for sharing about Utah, I did not know that. I’d be happy to guest post on your website – will reach out offline for topics unless you have specific ones in mind.

        Yes, please do come back and share the information you find out on minimizing taxes from self employment (as income grows) as well as leveraging tax favored vehicles such as the Roth. I’ll be waiting for an update! All the best

  7. Have you ever run into any articles of how the IRS would look at Vlogging income on YouTube if you were to be a S Corporation. Trying to figure if the IRS has a position on the SE tax for Bloggers and Vloggers

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